Seeking Alpha

Reviewing Your Portfolio's Returns And Riskiness

by: John Buckingham

The third quarter of 2018 is over, so it's time for another quarterly portfolio review.

There are quite a few things to look at, so I've structured this review as a series of questions which you may want to ask yourself on a regular basis.

First, a few general points:

  • The portfolio under review is my long-running 'defensive value' model portfolio.
  • It's a virtual portfolio but it's very realistic because a) it subtracts all trading fees and taxes and b) more than 90% of my family's pension savings are invested in exactly the same companies.
  • It holds shares in individual companies, not funds, ETFs, bonds or anything else.
  • If you like spreadsheets you can download my Portfolio Analysis Spreadsheet from the Free Resources page.

Are your portfolio's goals aligned with your investment goals?

If you don't know what your investment goals are then you should probably write them down. Weak goals are a problem and if you aim at nothing, that's what you'll get.

Broadly speaking, these are my investment goals:

  • To live off of the dividend income of my equity investments (at some point in the distant future)
  • To not be stressed-out by market volatility
  • To not lose lots of money on one bad decision
  • To enjoy the process

And here are the portfolio's goals:

  • Above average income:
    • A higher dividend yield than the All-Share (which is currently reinvested)
    • A progressively growing dividend
  • Above average growth:
    • Higher total returns than the All-Share over five years or more
    • Positive total returns over any five-year period
  • Below average risk:
    • Smaller peak-to-trough declines than the All-Share over five years or more
  • Long-term returns:
    • Grow to a million pounds before 2040.

For me, those goals are still appropriate.

And although it isn't a goal in itself, I think the only way to achieve reasonable long-term investment returns is to follow a systematic, logical approach to investing.

Investment rule

  • Know what your investment goals are.
  • Follow a systematic, logical approach to investing.

Okay, that's enough of goals.

Let's think about risk and diversity.

Is your portfolio over-exposed to the UK?

A lot of investors are negative on UK stocks. This shouldn't come as a surprise given the uncertainties surrounding Brexit.

This sort of geographic risk is inevitable and it's why I try to keep the model portfolio geographically diverse.

There are limits though, and since I'm a UK investor investing in the UK stock market, the UK was always going to be the portfolio's single biggest source of profits.

While significant exposure to the UK is inevitable, I don't want to be over-exposed (or under-exposed for that matter), so my general rule of thumb is:

Investment rule

  • Keep UK revenues (or profits) at less than 50% of the portfolio's total

The idea with 50% is that the portfolio won't be decimated if the UK economy goes down the tube, but it won't be left behind if the UK roars ahead either.

Currently, the portfolio's geographic diversity looks like this:

Value investing portfolio geographic diversity 2018 10The model portfolio is slightly overweight UK stocks

The portfolio is very slightly overweight UK stocks because that's where valuations are most attractive.

However, I realise that UK valuations are attractive because the risks are higher (or at least the uncertainty is higher) and I don't want to chase attractive valuations at the expense of geographic diversity.

In practical terms, this means I'm trying to avoid buying heavily UK-focused stocks at the moment. Instead, I'll buy slightly less attractive stocks that are more internationally focused.

It also means I'm looking to sell any UK holdings where valuations are not especially attractive. But there aren't many of those.

In fact, according to my stock screen the portfolio's seven least attractive holdings (out of 30) are all internationally focused, so selling UK-focused stocks is not going to be easy.

Having said that, I'm not desperate to shift the portfolio away from the UK given that its exposure is only 53%, which I don't think is excessive.

Is your portfolio over-exposed to any single company?

Perhaps the most obvious form of diversification in a portfolio of shares is diversification across many companies. For this, my rules are simple:

Investment rule

  • Hold around 30 companies
  • Start new investments off at around 3% to 4% of the portfolio
  • Sell half of a position if it grows to more than 6% of the portfolio
  • Don't invest more than 6% of the portfolio in total when topping up (e.g. start a new investment with 4%. It falls in value to 1% of the portfolio so you top it up with another 4%. The position size is now 5% but the total invested is 8%, which is too high)

With Brexit looming, it is inevitable that some companies will struggle while others will thrive.

Unfortunately, I have no crystal ball and I don't think anyone else does either, so broad diversification is vital if your sanity and your finances are to stay intact.

Here's a snapshot of what that sort of diversity looks like in practice:

Value investing portfolio holdings 2018 10A kaleidoscope of many companies, with none making up more than 5% of the portfolio

For me, 30 holdings feels about right.

There are enough companies so that when one of them shoots up or down in value it does not excessively excite or depress me, but there are few enough companies so that I can keep track of them without having to spend all day every day reading annual reports.

Is your portfolio over-exposed to any single sector?

In the context of Brexit, some sectors could do very well out of it while others could struggle. There have been various studies and reports published on this topic (such as this, this or this), but my basic assumption about sectors will remain the same.

In other words, I have no idea which sectors will do well or poorly, Brexit or not, so my policy is to diversify across many sectors. Specifically:

Investment rule

  • Don't own more than three companies from any one sector
  • Don't own more than three companies from all 'highly cyclical' sectors combined (i.e. commodities sectors and housebuilders).

Note that by 'sector' I mean the official FTSE ICB sector which you can find for each company on the London Stock Exchange website.

Given that I typically have around 3% in each holding, most sectors make up less than 10% of the portfolio. It could go as high as 15% or so, but that would be very unusual:

Value investing portfolio sector diversity 2018 10Exposure to many different sectors with none making up more than 15% of the portfolio

Let's shift gear from risk to returns by looking at the portfolio's performance relative to the FTSE All-Share.

Does your portfolio have a high dividend yield?

The portfolio's first goal is to always have a higher yield than the All-Share, and that's pretty easy to check by comparing the portfolio's current value to the total dividends paid (and reinvested) over the last year:

  • Model portfolio dividend yield = 4.0%
  • FTSE All-Share dividend yield = 3.4%

Obviously, the model portfolio's yield is ahead of its benchmark's, so that's good.

Of course, this is just the current yield and I want to make sure the yield is consistently above average, so here's a chart showing dividend yields over the last five years:

Dividend yield over 5 years to 2018 10The model portfolio has produced a consistently higher dividend yield

Fortunately, the portfolio's yield has consistently beaten the market's, but the gap has narrowed over time.

Another interesting feature is that the All-Share's yield is actually quite high and has generally been rising these past few years, which kind of blows a hole in the theory that the UK market is overvalued, or at the end of an overly-long bull run.

Overall, I'm happy that the portfolio has achieved its first goal of having a higher dividend yield than the market.

Long may it continue.

Does your portfolio have a progressive dividend?

At some point in the distant future, I may want to live off my portfolio's dividends, so I don't want the dividend to yo-yo up and down each year. Ideally, it would go up a bit every year, ahead of inflation and the cost of living (at the very least).

To achieve this, I only invest in companies with long histories of consistent dividend payments and relatively progressive dividend growth.

Investment rule

  • Only invest in companies with a ten-year unbroken track record of dividend payments
  • Only invest in companies where the dividend has grown faster than inflation over ten years

At the moment, the portfolio's dividend growth is boosted by the fact that its dividends are reinvested. So with that unfair advantage in mind, here's a chart showing the growth of annual dividends from the portfolio and its All-Share benchmark:

Value investing portfolio dividends 2018 10Dividend growth has so far been relatively steady and smooth

Although the dividend hasn't increased every single year, it's been pretty close and has been at least as progressive as the All-Share's dividend.

Has your portfolio grown faster than the market?

The portfolio's growth goal is to produce better total returns (i.e. income plus growth) than the All-Share over five years or more.

Why five years?

Because that's generally regarded as the minimum period over which equity investments should be measured.

In other words, it doesn't matter whether your portfolio was up or down last week, last month or even last year. What matters is how it performs over the long term, and five years is a good minimum definition for 'long term'.

Investment rule

  • Don't measure performance over the last week, month or year. Over such short time frames, the market's random walk is the dominant factor.
  • Use five years as the minimum performance time frame. Over five years or longer, the performance of the underlying companies begins to outweigh the market's random walk.

So is the model portfolio high growth? Here's the short answer:

  • Model portfolio total return over five years = 53.9% (9.0% annualised)
  • FTSE All-Share tracker total return over five years = 43.0% (7.4% annualised)

The model portfolio is ahead of its benchmark over the last five years, so it's on target in terms of total return.

To be honest, I'd really like double-digit annualised returns of 10% per year or more, but 9% per year will have to do for now. I'll need to do better over the next five years to stay on target for a million pounds by 2040.

As with the dividend yield, the result above is just the result for the latest five year period.

I want to beat the market over all five-year periods, so here's a chart showing rolling five-year total returns from inception (the portfolio started in 2011 so the first five-year period ended in 2016):

Rolling total return over 5 years to 2018 10The last few years have provided good steady returns to equity investors

An increase of around 50% every five years is another good rule of thumb, and so far that's been consistently achieved.

And in case you'd like to see a more traditional returns chart, here it is:

Value investing portfolio value 2018 10On a total return basis, the model portfolio and the All-Share have both performed well

Is your portfolio defensive when the market declines?

The post-crisis years have been relatively benign with a few 10% corrections here and there and a single very short-lived 20% decline along the way.

This is not an ideal environment to measure a portfolio's riskiness because the stock market hasn't suffered any major declines. In other words, you're not going to find out if a bullet-proof vest works by poking it with your finger.

However, I can't magic up a severe bear market just for testing purposes. I can only measure what I'm given, and what I've been given for almost ten years is a steadily rising market (with a few inevitable but minor dips).

So given that context, here's my preferred measure of riskiness (and stress):

  • Model portfolio largest decline in five years = 4.4%
  • FTSE All-Share largest decline in five years = 11.4%

The portfolio's largest decline in the last five years was less than five percent, so I'm quite pleased with that, especially when the market's largest decline was twice that.

There are various ways to reduce downside risk, not least of which are the company, sector and geographic diversification rules I've already mentioned.

Another way to try to reduce downside risk is to focus on defensive sector stocks such as utility companies, pharmaceutical companies and food or drink companies.

These sectors are generally less affected by the economic cycle and so, in theory, should decline less than most during a bear market.

This is how I try to maintain the model portfolio's defensiveness:

Investment rule

  • Have at least one third of the portfolio (e.g. 10 out of 30 stocks) invested in defensive sector stocks.
  • Have no more than one tenth of the portfolio (e.g. 3 out of 30 stocks) invested in highly cyclical sector stocks (e.g. commodities, house builders).

Another way to increase defensiveness and reduce risk is to hold more cash.

However, it's possible to take this too far and with a cash balance of more than 12%, I think that's true of the model portfolio.

I'm currently in the process of reducing that cash balance by investing slightly more into new investments (e.g. slightly over 4% rather than slightly over 3%), but it may take some time.

One other point is that those maximum decline figures were taken on October 1st, and since then the market has fallen further from its peak.

However, I don't want to calculate a mid-month decline figure because a) checking on a portfolio more than once per month is a waste of time and b) the market may have recovered by the start of November.

In other words, if the market falls and recovers in less than a month then as far as I'm concerned it didn't happen.

Is your portfolio on target to achieve its long-term goals?

The model portfolio's long-term goal is to reach a million pounds before 2040.

The portfolio started with a value of £50,000 in 2011, so to achieve that goal it needs to double every seven years or so, which is a growth rate of around 10% per year.

Or to be precise, if it is to grow from £50,000 to £1,000,000 by 2041 (i.e. over 30 years from inception) then it needs to grow by at least 10.5% per year.

If it had been growing at 10.5% per year so far then by the end of 2018 it would have a value of £111,000.

Currently, the portfolio's value is £102,000, which is close enough that I'm not really worried. Although of course, it's better to be ahead than behind.

Overall then, I'm happy with the portfolio's progress, although more returns and less risk would be nice.

So are your investments on target? Are they growing as you'd like them to grow, or paying dividends at the rate you'd like? Or do you need to adjust your savings rate, your expectations or your investment strategy?